Capital Offense: How Washington's Wise Men Turned America's Future Over to Wall Street

Why every president from Reagan through Obama has put Wall Street before Main StreetOver the last few decades, Washington’s firmly held belief that if you make investors happy, a booming economy will follow has caused an economic crisis in Asia, hardship in Latin America, and now a severe recession in America and Europe. How did the best and brightest of our time allow this to happen? Why have these disasters done nothing to change the free-market mantra of the Washington faithful? The answer has nothing to do with lobbyists and everything to do with ideology. In Capital Offense, veteran Newsweek reporter Michael Hirsh gives us a colorful narrative history of the era he calls the Age of Capital, telling the story through the eyes of its key players, from Ronald Reagan and Milton Friedman through Larry Summers and Timothy Geithner. • Based on the solid research and skilled reporting of Newsweek Senior Editor Michael Hirsh• Takes you inside high-level, closed-door conversations of top White House advisers and administration officials such as Alan Greenspan, Robert Rubin, Paul O’Neill, and others• Illuminates key figures and lively interpersonal clashes, including the conflict between Larry Summers and Nobel Prize-winning economist Joe Stiglitz • Offers crucial insights on why President Obama took so long to work on the economy—and why he may not be going far enough• Catalogs the missteps of three decades of fiscal, regulatory, and financial recklessness, including the dismantling of the Glass-Steagall Act, the S&L debacle, Enron, and the subprime mortgage meltdownAs we struggle to emerge from the financial crisis, one thing seems certain: Wall Street’s continued dominance of the global economy. Propelled into the lead by a generation of Washington policy-makers, Wall Street will continue to stay ahead of them.

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6
Portrait of a Contrarian
He was from Gary, Indiana. You couldn’t understand Joseph Stiglitz without understanding that.
Some people are more shaped by their hometowns than others. The little girl who was to become Ayn Rand had pined for a way out of Bolshevik-besieged St. Petersburg. Sickened by the lies that haunted the days and nights of her youth—the sham that was Bolshevik collectivism—Alice Rosenbaum dreamed of a golden land, an America of free men and action. What she didn’t find she invented, so powerful were the ideals she had passionately conjured in Petrograd.
Stiglitz was born in America, and in a place where the world wasn’t golden at all but workaday gray, indeed notorious as one of the grimmest places in the United States. And in his own way young Joe Stiglitz grew to be just as uncompromising as Alice Rosenbaum became about what he had learned from the intrusions of the real world. In his case the lesson was almost the opposite. It was that markets don’t work well at all in practice, at least on their own. Indeed, for all Stiglitz’s brilliance at mathematical models, one could draw a direct line from his upbringing in Gary to his defiant declaration fifty years later in Stockholm, as he delivered his Nobel Prize lecture, that Adam Smith’s “invisible hand” didn’t exist at all—or if it did, it was surely “palsied.”
Stiglitz, a fourth-generation American born in 1943, came from a Jewish family who were all Midwesterners. The Stiglitz family hailed from Belarus and other parts of Eastern Europe way back when, but was part of one of the earliest waves of Jewish immigration, settling in Cincinnati back in the 1850s. (Some kept going farther west: one of Stiglitz’s great-aunts taught Ronald Reagan in grade school in Dixon, Illinois.) Stiglitz’s parents, Nathaniel and Charlotte, both had been born within six miles of Gary, in 1903 and 1904, respectively, in the towns of East Chicago and Lyding. It was something of an irony that the adversaries Stiglitz later took on as an economist, the Chicago school, weren’t really from Chicago at all, while he himself was a born and bred “freshwater” Midwesterner steeped in the problems of the industrial middle class that the Chicago school tended to ignore. The Chicago school, after all, was mainly Milton Friedman’s progeny. Friedman had been born in Brooklyn and raised in New Jersey.
Stiglitz was also surrounded by immigrants when he was growing up. Many were Eastern Europeans who also had sought a better life, and many found it in the steel mills. But unlike Milton Friedman’s mother, they weren’t going anywhere, and they found themselves subject to the periodic layoffs that U.S. Steel and other giants imposed. For many in the industrial heartland, life never seemed to get better. His hometown, Gary, was invented by a classic American robber baron: Elbert H. Gary, the chairman of U.S. Steel, who founded the city in 1906 as the company’s headquarters and decided to name it after himself rather than the president, W. E. Corey, to show who was in charge. Gary was a remarkable figure, a lawyer and judge who took a parental interest in “his” town and talked of cooperation with government but doggedly opposed labor unions. Vain about his ramrod posture and manicured mustache—and connections to European royalty—Gary declined to meet with labor representatives, whom he considered social inferiors. He constantly quoted scripture to support his policies, but refused to recognize the Sabbath as a day of rest for his workers. When Teddy Roosevelt accused U.S. Steel of being a “trust” and sought to break it up, Gary welcomed the description and then won a Supreme Court decision legitimizing the steel giant. By 1919, workers were comparing him to the German Kaiser, a local Indiana history recounts, after he stood against their demand for an eight-hour rather than a twelve-hour day. One cartoon juxtaposed the judge’s statement, “The workmen prefer the longer hours,” with pictures of tired, gaunt laborers.
By the time Stiglitz was growing up in the 1940s and 1950s, Gary had settled into industrial torpor even in the boom postwar years. “There must be something in the air here which leads one to ask questions,” Stiglitz later said as he narrated an adulatory French documentary called Le Monde Selon Stiglitz—The World According to Stiglitz. “Poverty, discrimination, unemployment were all around us. These things mark a man for life and make him want to understand. Having seen the downside of a market economy, it would be impossible to be euphoric about its marvels.” The railroad tracks ran next to his house, and the trains passed every thirty minutes. His own family life was a in state of constant struggle.
His father, Nate Stiglitz, a towering man who lived to the age of ninety-six, was not known for his business sense. He tried several different occupations before settling on insurance, which he sold out of a small office in the big bank building downtown, Gary’s only “skyscraper.” Though his father was a “Jeffersonian Democrat” who believed passionately in self-reliance and disliked big government, Stiglitz later said, “he had a deep sense of civic and moral responsibility. He was one of the few people I knew who insisted on paying Social Security contributions for household help—regardless of whether they wanted it or not; he knew they would need it when they were old.” Nate kept the family in the black, and it wasn’t a bad childhood, all in all. Stiglitz’s mother, Charlotte, pampered Joe, his older brother, Mark, and their younger sister, Eloise, never asking them to help around the house or pick up after themselves. They managed to stay “middle class” and even had a maid. But the economically dispossessed, the truly poor, were never far away.
Stiglitz remembered his first dim realization that something was wrong with America: around the house and the dinner table. The Stiglitzes’ maid, Minnie Fae Ellis, was from the South and had a sixth-grade education, and like the other inner-city blacks lived across the tracks from the Stiglitz home. “I remember thinking why do we still have people who have a six-grade education?” he recalled. Out in the streets, the cyclical layoffs were a constant presence, and pollutants clung to the wash that his mother hung out in the back yard. Visiting their cousins, the Fishmans in Chicago, they always were made aware they had less: fewer toys, and no summer home up on Lake Michigan like the others in the family. His sister, Eloise, who was six years younger, ran home one day to tell the family about the “cool rainbow” she saw in the Calumet River, only to be informed it was oil seepage. The ethos of the steel industry was everywhere, even in their religion. “Because of economic conditions and makeup of community, observing the Sabbath became very difficult,” recalled Joe’s older cousin Roberta. “Saturday was a big day for cleaning and laundering for people working in the steel plant. So orthodoxy diminished. My grandmother basically kept a kosher home.” When young Joe and his older brother, Mark, came home from Hebrew school one time and said they wanted to keep kosher, their father said, “That’s not going to happen.”
As Stiglitz’s father grimly prospered in his task as insurance salesman, the talk around the dinner table was about antitrust, fighting off the banks that tried to press insurance policies on their customers when they took out mortgages. It was no accident that Joe Stiglitz’s early work on the fallacies of markets focused on the unequal relationship between insurance companies and those they insured, and the lack of good information shared between them. Those who seek insurance always know more about their actual health than the companies, which in response are habitually suspicious and always look for loopholes to deny coverage, like “preexisting conditions.” Stiglitz’s conclusion came to be that universal coverage is the only answer.
Above all there was his mother, who told him simply to “use your head and do service” for his career, advice that his sister, Eloise, would call a “fundamental guiding post” in his later work. Stiglitz would quote that line from Charlotte at her funeral. But he always had his feet grounded in the markets. As high school valedictorian in 1960, young Joe gave a speech praising U.S. Steel as a somewhat stable supplier of jobs. His uncle, Isidore Fishman, sitting in the audience, remarked, “Oh my God, I have a Republican nephew. Where did he come from?”
Joe, a middle child, was an academic phenomenon from an early age, becoming debating and spelling bee champ and winning the state math competition. He was often fired up by a rivalry with his older brother, Mark—also brilliant—that would later lead to an estrangement. Mark was tall, handsome, and four years older; some in the family, including Joe’s cousin Roberta, recalled that Stiglitz didn’t even speak at all until he was three and depended on Mark to represent him to the outside world. “Mark spoke for him. Joe would mumble something, and Mark would point to the cereal box,” she said. Mark Stiglitz later graduated from Harvard Medical School; but as his brother’s fame grew, he not only stopped translating for Joe, he eventually stopped communicating with the family altogether and changed his last name to “Lawrence.”
At age twelve, Joe Stiglitz was already using college textbooks; off in a corner of the classroom, indulged by his overawed teachers, he would enter a world of his own dreaming. The family loved to tell the story of how, rushing off to school one morning, he got stuck in a mud patch and lost his shoe but ran on anyway so he wouldn’t miss class. Like a lot of brilliant young men who later became economists, Stiglitz loved math but wasn’t really attuned to the cloistered life of academe. He wanted to be a professor, but a psychological test at school concluded that he should “be a rabbi or a preacher,” he recalled. In truth, he wanted to change the world, and for mathematically talented young idealists economics was the only choice, as Milton Friedman found out. Stiglitz’s contemporary Paul Krugman, also later to be a Nobel Prize winner, had similar yearnings. He fell in love with Isaac Asimov’s Foundation trilogy when he was a teenager because its hero was a brilliant “psychohistorian” who mathematically developed a science of history that allowed him to predict the future and save civilization. “I wanted to be a psychohistorian,” Krugman once told me. “Economics is about as close as you can get.”
A science to save civilization. It was the sort of grandiose self-regard that all economists seemed to have for themselves. The joke on economists, said one of them, Robert Johnson, “is that they model the rest of us as venal and have a blind spot regarding themselves. They see themselves as benevolent Martians who try to make the earthlings better off.” The Friedmanites had modeled the rest of humanity as rational, self-interested actors, but failed to see that the way they squabbled over their own theories was itself evidence of how flawed that concept was. It was a phenomenon that Stiglitz would suffer with his own career: his “rabbinical” yearning to save the world like one of Asimov’s psychohistorians would be frustrated by his own conclusions showing that economics could never, in fact, be certain about anything.
Stiglitz was accepted at Harvard but, on the advice of his brother—who, like him, was a National Merit Scholar and valedictorian of his class—felt it was too much of a “big-city” school. He turned down Harvard and went to Amherst instead. Soon Stiglitz was agitating, leading the antifraternity campaign there and getting himself elected president of the student council. The school’s fraternities drew school financing to travel to matches and games during breaks, which Stiglitz thought was unfair. So he facetiously started a “caber-tossing team” and petitioned for money to go to Scotland. The school had no choice but to drop the subsidy program. Around the same time he took part in the civil rights march on Washington, D.C., in 1963 and heard Martin Luther King Jr. give his “I Have a Dream” speech. By his third year Stiglitz was renowned on campus as an academic superstar, and his professor was calling MIT and saying, “You’ve got to take this guy.”
Gary never stopped haunting him. And he discovered that in a strange way, the example of Gary was haunting his chosen field of economics as well. At MIT in the 1960s Stiglitz came to realize that the Chicago school was already dominant, but few people outside Chicago took those perfect-competition models seriously. The problem was there was no real alternative to these models. So economists were simply using them because they had no other model.
Stiglitz, his liberal passions engaged as much as his intellect, grew obsessed with the idea that the perfect competition models couldn’t be right. He saw, in his own hometown, the destruction of the industrial middle class unfold. And so, somewhat like Brooksley Born, who hadn’t bought the free-market religion because she was a lawyer whose world view was shaped in Washington, Joe Stiglitz developed his own immunity to market fervor.
The models of the time assumed that where perfect competition failed to occur, these were minor flaws in the rationalist model. In fact, Stiglitz eventually showed, these seemingly small factors destroyed the model. The Chicago school thought that information was just another factor, another input, slightly altering the equation. Stiglitz’s work showed that was wrong: even a small amount of imperfect information could destroy an economic equilibrium. Here Stiglitz was just describing what he’d seen in Gary and later on, in Africa: under the perfect-competition model, wages were supposed to drop during a recession, and employment levels would remain the same at lower costs. It didn’t work that way in real life: Wages were “sticky,” and didn’t drop right away. At lower wages work habits also changed, to a degree employers didn’t realize; workers would work less hard, leading to less productivity, which in turn deepened the recession. Things didn’t simply return to “equilibrium” on their own.
Similarly, Stiglitz showed, banks would “ration” credit out stingily in tough times, fearing what they suspected but didn’t know for sure: that borrowers were much less likely to be able to pay off, also prolonging a downturn. That undermined the perfect-competition model, according to which the banks should continue the same level of lending but simply raise interest rates to higher-risk borrowers. He showed that the efficient markets hypothesis, based on the idea that the stock market fully reflected all information, didn’t add up for the simple reason that if it did, there would be no incentive for anyone to pay money to get information. Stiglitz and his academic allies also demonstrated the flaws in Joseph Schumpeter’s famous thesis of “creative destruction,” which postulated that healthy capitalism inevitably produces innovative entrepreneurs who destroy monopolies; Stiglitz showed that monopolies could persist indefinitely by blocking the entry of competitors.
The free-market school believed that Adam Smith’s “invisible hand” always guided behavior correctly; unemployment shouldn’t exist at all if the market was left to work properly. Stiglitz, raised in an environment of chronic unemployment, saw it didn’t work that way, and he concluded that the only agent powerful enough to correct the failings of the market was government. To make his case, once again he began to use the rationalist school’s own tools against them. He constructed an elegant mathematical model showing that if one assumes rational expectations of the future among market participants, not only would unemployment persist but government spending programs could be even more effective in reducing it (because the rational expectation of higher income from government programs translated into more consumption in the present). In more practical terms, Stiglitz wrote a paper showing, for example, that World War II was not just a pick-me-up from the Depression; it represented extraordinarily successful industrial policy too, getting people off Depression-ravaged farms and into factories, permanently upgrading the U.S. economy.
The skepticism engendered in Gary was deepened when he went off to Kenya to study after graduation in 1969. What he saw there confirmed what he had experienced as a boy in Gary. All markets did not, in fact, “clear”—with buyers and sellers finding each other at the right price—on their own. Sometimes they would just stagnate. His longtime friend George Akerlof, with whom he shared the Nobel Prize, later said that for both of them the time spent studying in desperate Third World economies changed their views forever. “The year after I went to India, he went to Kenya,” recalled Akerlof. “We basically did the same thing . . . and somehow we see the world a little bit differently. Life isn’t so much what it appears to be. We knew that capital account liberalization was a bad thing” because so few developing countries were even close to being ready for flows of sophisticated capital.
And more, they saw that the details of markets and the peculiar conditions of individual countries mattered. “I had seen cyclical unemployment—sometimes quite large—and the hardship it brought as I grew up,” Stiglitz later said in his Nobel lecture, “but I had not seen the massive unemployment that characterized African cities, unemployment that could not be explained either by unions or minimum wage laws (which, even when they existed, were regularly circumvented). Again, there was a massive discrepancy between the models we had been taught and what I saw.”
Milton Friedman loved to point to Hong Kong as a nearly perfect free market. Stiglitz wrote a paper on Hong Kong at one point, showing that the role of government was actually pretty large in what Friedman considered to be the “freest market on earth.” In his Nobel lecture Stiglitz said that may be true, but “the government was the major provider of public housing and it had a lot of influence on rule of law. The free market operated within the context of a positive government.”
Paper by paper, Stiglitz and his colleagues began to prove, in effect, that market failures happen all the time, and government intervention is needed on a regular basis. The myth of perfect markets was just that, a myth. Stiglitz wanted a “third way” that found a balance between market forces and government oversight. His sense of certainty about these results made him out of joint with his times. While the Reagan revolution was taking off, Stiglitz and his colleagues were already starting to win Nobel Prizes for demonstrating the fallacies of free markets. And there was no real critique of this approach from the Right.
What the Right did was to ignore the Stiglitz critique. The Friedman school never developed an overarching theory to counter Keynes. Instead, Stiglitz would complain, conservatives only employed the rhetoric of theory in the debates over public policy. After all, their ideas were far easier to explain to the public, and their policies—simply let the market rip—were far easier to think up and enact.
As Stiglitz worked prodigiously in developing his theories, his reputation grew within academia. He won the Clark medal. And then one day a call came from Little Rock. Laura D’Andrea Tyson, the newly named chairwoman of Bill Clinton’s Council of Economic Advisors, wanted him on board.
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Stiglitz was excited about going to Washington. He was eager to “test his theories to see if they worked,” recalled his sister, Eloise. “I remember him saying how interesting it was to figure out a strategy to get your idea across. . . . Political gamesmanship to get your idea accepted. At first he really enjoyed it. Then he reached the point where he didn’t.”
Stiglitz’s early introduction to the Clinton administration was congenial. There was an enormous sense of possibility about what government could do. The failure of health care, the 1994 Gingrich revolution, and the rise of the Wall Street-Treasury axis were still ahead of them. Stiglitz had been chosen, after all, because he specialized in finding fault with markets and where government could help. No one really saw him as arrogant then. They only saw his lovable, absentminded side. At one early meeting of the economic team, twenty minutes in, the budget director, Leon Panetta, who had been staring at Stiglitz, jumped up, exclaimed, “I can’t stand it anymore!” and walked over behind him and fixed his tie, which Stiglitz had put on top of his collar rather than beneath it.
But the bonhomie didn’t last. When Stiglitz went to Washington, even after he took over the chairmanship of the Council of Economic Advisors in 1995 when Laura Tyson decided to return to California, he found that no one cared about his findings. Efficient markets theory ruled the landscape. Stiglitz quickly saw that Rubinomics—and the Washington Consensus—was turning into the law of the land. Stiglitz would find himself getting increasingly agitated as he sought to argue that markets don’t solve all problems at once. Globalization had enormous benefits, but he knew it had also destroyed the steel industry and with it Gary, Indiana—the very neighborhoods he’d roamed as a boy. The jobs were gone, and there was nothing to replace them. This was happening all over the country to America’s industrial middle class, the very consumer base that the rest of the world relied on.
For Stiglitz, his early 1990s debate with Larry Summers over capital liberalization was only the beginning of what was to become an epic rivalry—and a fairly faint beginning compared to what was to come. Before long, Stiglitz found he was taking on all of Washington.
The keepers of the Washington Consensus existed—and still do—in a four-block bastion of economic orthodoxy in downtown Washington. It lies physically on Pennsylvania Avenue between Fifteenth Street, home of the U.S. Treasury Department, and the Nineteenth Street headquarters of the International Monetary Fund, with the Eighteenth Street building of the World Bank in between and the Federal Reserve a couple of blocks to the south. Though the World Bank and the IMF are made up of economists and policy makers from more than a hundred countries, as the 1990s went on most of them began converging around the same post-Cold War market consensus that Rubin and Summers were part of. Prodded by the American policy makers a few blocks away, animated by the same free-market evangelism, the IMF was intent on dictating when and how nations would open their markets, how small and austere they would make their national budgets, and so forth. The fund’s economists forbade alternative approaches, like the East Asian “model” of maintaining partially closed economies and promoting exports during a country’s development phase, before it hits full industrialization. This was used to differing degrees not only by such major nations as Japan and China but by the United States itself during its own developmental period in the nineteenth century.
The Washington Consensus, even more than Larry Summers, would become Joe Stiglitz’s nemesis.
After capital liberalization, Stiglitz’s next big fight was over Russia. Once again he was alarmed by the rush to open things up. Soon after the Soviet Union disappeared from the map in the early 1990s, Moscow heard a lot of blithe, promarket rhetoric from the Bush and Clinton administrations, and it was the subject of much high-minded tinkering by the free-market consultants at the Harvard Institute for International Development, as well as the IMF. Citing their Western-trained advisers, both former Soviet leader Mikhail Gorbachev and his successor, Russian president Boris Yeltsin, confidently predicted a two-year transition to a market economy. But Washington didn’t provide much help or support in institution building; its rather poor substitute was to ally itself with the power base of an increasingly addled Yeltsin. Privatization of the former communist production system quickly degenerated into what the Russians called “grabitization,” the unfair seizure of old state assets by party apparatchiks-turned-oligarchs with insider connections. When the West did finally send over boatloads of IMF assistance, things were so far gone that the aid only led to massive capital flight. World markets attacked the ruble, and Russia fell into a long economic slide. “By paying insufficient attention to the institutional infrastructure that would allow a market economy to flourish—and by easing the flow of capital in and out of Russia—the IMF and Treasury had laid the groundwork for the oligarchs’ plundering,” Stiglitz wrote later. “While the government lacked the money to pay pensioners, the oligarchs were sending money obtained by stripping assets and selling the country’s precious national resources into Cypriot and Swiss bank accounts.”
Stiglitz debated Summers and Harvard economist Jeffrey Sachs, a leading proponent of fast marketization, on this issue at the beginning of the 1990s. “They thought you needed to pursue privatization rapidly and that infrastructure would follow,” Stiglitz said. “It was a divide then. You can’t talk about property rights in the absence of rule of law. In Russia, you gave them control rights. In fact, with capital market liberalization, it was the worst of all possible worlds.” In other words, the Russian apparatchiks-cum-oligarchs were using their power to steal state assets and then, with open capital markets, to ferret that huge amount of wealth safely offshore. “At least if you stop capital flight they would say, we’d better invest here,” said Stiglitz. “It was an intellectually incoherent view.”
The irony was that, at home, it was not as if the U.S. government suddenly threw off the welfare state and let markets rampage. U.S. policy makers hadn’t truly practiced laissez-faire economics at home since Calvin Coolidge’s day. Again, even Ronald Reagan ran record deficits in order to support FDR’s welfare state. Indeed, government spending as a percentage of GDP actually rose during his term. Nonetheless, when it came to promulgating U.S. economic ideas abroad in the post-Cold War era, America’s top policy makers ended up giving different advice abroad than they would have at home. There may have been an entrenched welfare state in the United States, but developing economies, especially newly enfranchised economies such as post-Soviet Russia, provided a clean slate for rapid marketization.
Jeff Sachs was no free-market ideologue, but he too got caught up in the furor. In the immediate aftermath of the Cold War, Sachs had stopped hyperinflation in Bolivia, then in Poland. But privatization of the former Soviet economy was a bridge too far into marketization. In the summer of 1990, Sachs and his colleague David Lipton were invited into the once-cloistered sanctum of Gosplan to talk about reform. “In my own thinking I had treated Russia like Poland, only four times larger and perhaps ten times harder,” he wrote. Moscow hired Sachs and Harvard’s Institute for International Development, but the level of corruption and the lack of preparedness for capitalism were much greater in Russia, which hadn’t ever really experienced it, having gone almost directly from serfdom to socialism. Sachs also came to believe that Washington was not nearly as eager to help Russia get on its feet as it was Poland, which was welcomed into Europe and NATO. He finally quit in early 1994, fed up with the endless turf-fighting between “reformers” and the communist old guard and blamed the lack of Western aid support for his failure.
Later on, after the disaster of grabitization, even Milton Friedman would come to agree that Stiglitz’s more subtle analysis had been largely right. Stiglitz and Friedman came to have enormous respect for each other and sometimes saluted each other across the gulf of economic war. “I’m very much on his side,” Friedman eventually told me in 2002. “You need more than privatization. What you need as a basic element is the rule of law. I don’t go all the way with Joe. He stresses the problem of providing a safety net. Which will enable people to own property. Take the Russian case, even today most land in Russia will not be privately owned. It’s interesting China is doing much better on that issue than Russia. You do need rule of law.” In the immediate aftermath of the fall of the Soviet Union, Friedman said, “I kept being asked what Russia should do. I said, privatize, privatize, privatize. I was wrong. He was right. What we want is privatization and the rule of law. I remain persuaded that free markets are a necessary ingredient of the solution.” Then he added: “One of the things Joe tends to stress that I would disagree with is the need for regulation.”
Despite their early tussle over liberalization, it wasn’t until the mid-to late 1990s that the Stiglitz-Summers rivalry grew explosive. Things came to a head soon after Stiglitz moved over to the World Bank as its chief economist in 1997. In early July of that year, the government of Thailand abandoned its long-standing policy of fixing the value of the baht against the dollar, and the baht began plunging. It was the beginning of the Asian contagion, and its outcome was to change the lives of both Stiglitz and Summers.
Thailand, like a lot of East Asian countries, had gotten fat and lazy on enormous inflows of eager Western capital looking to pile onto the “Asian miracle.” The Asians had been doing fine before with their own high domestic savings rates, but capital liberalization precipitated a rush of Western money. In the mid-1990s, a strengthening dollar made Thailand’s roaring export industries more expensive—because of the fixed currency rate—and exports fell off. Meanwhile, the Thais kept borrowing all those dollar-denominated debts, doing heavily leveraged derivatives trades with Western banks, and piling up a trade deficit. Thailand, of course, was one of those countries that had opened up to foreign capital. In late 1992, Bangkok created a new foreign banking center intended to attract capital from around the globe. Thai banks paid higher interest rates, which made it an attractive center, and the fixed exchange rate meant no worries about fluctuations.
Thai borrowers meanwhile paid lower rates if they borrowed in dollars, and they took on a lot of short-term debt in dollars to invest in the overheated Thai real estate market. In early 1997, rumors began spreading that many Thai borrowers were near default, and Western hedge funds began selling the baht short, betting that Bangkok couldn’t maintain the link to the dollar. When a government ties its currency to the dollar, it has to maintain a huge surplus of dollars. To make good on its promise that the two currencies are interchangeable, the government must have enough dollars on hand to trade them with any investor who wants to hand over his baht. But now speculators were betting that the government would run out of dollars. Many Thai firms began trading their baht for dollars in order to pay off their dollar debt. The baht sales became a torrent. The IMF orchestrated a $17 billion bailout on July 2. A little later, Indonesia found itself in similar trouble and got a $42 billion rescue.
In return, though, the IMF insisted on even more financial openings. And it jacked up interest rates to make the currencies more attractive, stopping the outflow. The Asians themselves were stunned: they had high savings rates, disciplined budgets. Why would their currencies suddenly collapse? To many observers at the time—including me, covering it for Newsweek—it was the latest evidence that U.S.-style economic thinking was elbowing out the once championed “Asia model.” Robert Solomon, a former Federal Reserve official, noted wryly to me that “for some inexplicable reason, every Anglo-Saxon economy in the world is doing well now”—free-market countries like Britain, Canada, Australia, and New Zealand.
Stiglitz, more than most, saw that there was something different about this crisis. Everyone knew that the countries in East Asia had low inflation and, as Stiglitz put it in a feisty speech in April 1998, “a fiscal stance and public debt-to-GDP ratios that were the envy of even the most responsible industrial economies.” This was not the Latin American or the peso crisis. Wasn’t it a bit odd, he asked, that only a few years earlier Western economists were praising the Asians for their willingness to compete openly in international markets, and now they were saying these economies weren’t open enough? For the past several decades, the East Asian “model” of relatively open trade and government-controlled capital markets had “delivered the most impressive level of increases in GDP that have ever been attained in such a short span,” Stiglitz said. Now they were being belittled as “crony capitalism.” Strange.
Beyond that, if financial markets were so often irrational and therefore it was difficult to say what might restore confidence, then how was it the IMF was so certain that its remedies would do so? Stiglitz grew contemptuous of the IMF’s staff economists, and he would later make many enemies there by publicly calling them “third-rank students from first-rate universities.” He was convinced they didn’t understand the underlying problems—the so-called microeconomics that explained how market participants like households and companies actually made decisions—and that the single biggest problem was capital market liberalization. He pushed for a deeper analysis more attuned to the specifics of Asia, and its relationship with the big banks.
Stiglitz thought that the IMF’s conditions were simply causing a lot of unnecessary pain. Once again, his own work guided his way and gave him the backbone to stand up to what seemed all of Washington. Stiglitz’s theories had shown that it was far too simplistic to assume that higher rates will attract foreign investors and lenders—or will stop them from fleeing. His work showed that in the absence of good information—and there wasn’t much of it in those hectic months—investors and lenders can’t discriminate well between good and bad deals; in the fog of a crisis, higher interest rates might simply signal that those paying them are more likely to default. At the same time, higher interest rates would do long-term damage, putting banks out of business. The resulting deeper recession in the country would just make foreign capital flee faster, defeating the original purpose of raising interest rates.
Stiglitz preferred capital controls to jacking up interest rates. Why not just make it a little more difficult to trade all that hot money by placing a tax on it, or putting a time limit of, say, a year on investments before they could be pulled out of the country? That’s what Malaysia did. When speculators began selling the Malaysian ringgit, the country’s outspoken prime minister, Mahathir Mohammad, tore into George Soros, calling him a “moron” and saying that all foreign money traders were “racists” and “wild beasts.” Mahathir then imposed capital controls. It was, of course, just a reassertion of the alternative model of development that all these countries, beginning with Japan, had represented. But that was now heresy against the Washington Consensus and Summers; it meant that government somehow knew better than the financial markets, and that was impossible. So it was never even considered.
Larry Summers never bought completely into the idea of strict “conditionality” for the Asian economies in return for bailouts. Privately he was more willing than Rubin to simply prop them up with funds without asking for political concessions in return, but once again Summers went along with the prevailing wisdom. Still, Stiglitz was angry about the way the debate had narrowed, that the East Asia model was being ignored. Sensible solutions left behind by the rigid Washington Consensus were no longer even considered. He was appalled by all the unnecessary pain. Banks were defaulting, and they would continue to default at a greater rate if interest rates were raised to keep capital flowing in. People’s lives were being destroyed by a wrong headed idea. And of course there was his personal pique at the idea that the IMF had slighted his own vast body of work.
Stiglitz could no longer contain his outrage. In September 1997, at the annual meeting of the IMF and World Bank in Hong Kong, Stiglitz committed his first act of what would later be seen as ideological treason by Summers and others. He met privately with a group of East Asian finance ministers, and urged them to push ahead with a plan to impose capital controls. They never went ahead with it, except for Malaysia.
Jeff Sachs was on Stiglitz’s side now. Sachs had never lived down his checkered experience with “shock therapy” in the early 1990s—which worked brilliantly in Eastern European countries like Poland, but proved disastrous in Russia. Indeed, Sachs disowned all responsibility for what happened in Russia, to the point where he would erupt at anyone who brought the subject up, as I learned when I moderated a panel discussion including him at Harvard in 1999. I asked him what I thought was a delicately phrased question: whether his experience at shock therapy had “informed” his new work as a development economist in the poorest nations in any way. Sachs erupted in anger, calling the question a “cheap shot.” But of course it was just an uncomfortable reminder. (After he calmed down, Sachs did admit that his new work represented “an evolution of my personal efforts since the mid-1990s.”)
The Asians never forgot Stiglitz’s support. Later on Stiglitz would be criticized for being too passionate in defense of his theories when practical solutions were needed. “Joe’s brilliant. But his problem is that he tends to leap to the conclusion: okay, this market isn’t working very well. How can government make it better?” said one of his allies. “He doesn’t pay enough attention to the possibility that government will get it wrong.” But Stiglitz also saw that something much larger was going on: What was emerging on the global stage was a great test of alternative theories to economic development. The Cold War had not been just a contest of Soviet-style command economics versus free markets for goods and services. There was also the Chinese middle way out of communism, a way that had been paved by Japan’s postwar “mixed economy.” Those economies benefited from market discipline, but they didn’t embrace fully free trade and capital. Yet almost no one was paying attention to these nuances or taking lessons from them. Fifteen years on, the Chinese experiment seemed to be succeeding brilliantly, just as Japan once had, bringing double-digit growth every year. Stiglitz understood that the dramatically different approaches to reform taken by communist China and Russia—gradualism versus shock therapy—were “one of the most important sets of economic and social experiments ever conducted,” as he said at the time. There was, Stiglitz believed, a genuine alternative model to growth being born in Asia.
Summers was still going in the opposite direction. That same month he called Eisuke Sakakibara, Japan’s vice minister for international affairs, and angrily protested that he’d just heard of the Japanese minister’s plans for an Asian Monetary Fund. Sakakibara was one of Asia’s intellectual champions for an alternative model. “This is not an Asia crisis, it is a crisis of global capitalism,” Sakakibara warned me. “Global capital markets are responsible to a substantial degree. If you look at the so-called Asia crisis, the root cause has been the huge inflow of capital into Malaysia, Thailand, Korea and China,” Sakakibara told me around that time. “And all of a sudden, due to some trigger mechanism, all of that has [fled] from those countries. Borrowers have been borrowing recklessly, and lenders have been lending recklessly. And not just Japanese banks. American banks and European banks as well.”
Sakakibara was actually in league with Stiglitz and Sachs. (Interestingly, Mahathir and Soros were also later to join forces and condemn the system of capital flows that the Clinton Treasury Department had sponsored.) Summers was alarmed by this unexpected insurgency: the idea of an Asian Monetary Fund raised the prospect of an alternative power center, one where the Treasury and IMF conditions for reform might be thrown out or undermined. “You would have competing IMFs,” Rubin said later. “That would be used to lessen conditionality”—removing Washington’s leverage. So Summers sprang into action, squelching the idea in a series of meetings in Asia. Rubin and Greenspan also wrote a letter denouncing the Asian Monetary Fund. The hubris of the Washington power elites in economics during this era was not unlike that of the Bush administration in the national-security realm after 9/11. For Summers especially, Stiglitz’s constant kibitzing—and his habit of taking sides with the Asians—was getting a bit much to take.
9
The Last Guy at the Alamo
By the late 1990s virtually every dissenter was being ignored, like Joe Stiglitz and Frank Partnoy, or pushed from office like Brooksley Born, or co-opted like Jerry Corrigan. The zeitgeist had become almost a religion, the hounding of dissenters very nearly inquisitorial. And the phenomenon was going global; it was no accident that much later on the chairman of Great Britain’s Financial Services Authority, Adair Turner, would describe himself ironically as “high priest of a particular religious cult.” The cult’s central tenet was that financial innovation was perfecting capitalism and that tampering with that process was a form of apostasy. Whether you were Brooksley Born or Joseph Stiglitz—or even Jerry Corrigan—you eventually found out you were taking on an entire era, a mode of thinking that permeated the times and simply didn’t allow any doubts to surface. Wall Street lobbies had always been persuasive—campaign contributions often make an argument more compelling—but now they were making their arguments in an environment in which people really did believe the Wall Street way was always the smartest way. In that environment the Mark Brickells would always win against the Jim Leaches.
And now these forces were emanating from Washington into the rest of the country. It was there, out in the heartland, where individuals like Roy Barnes would make the last stand against the financial free-market revolution.
Barnes was a self-described “small-town lawyer” from Mableton, Georgia, just outside Atlanta, with a mane of silver hair and an Andy Griffith drawl. Like Ben Matlock, the TV character he resembled, Barnes was the farthest thing from a rube. He had come from a family of bankers and described himself as “a capitalist through and through.” And as early as the 1980s Barnes saw, long before many in Washington, what was happening as deregulation took lending farther from the local banks and gave it to mortgage brokers and Wall Street, where no one cared much if the loans were good or bad as they were bundled into securities sold around the world. Georgia, like other states, had tried to fight off predatory lending. Barnes had led the effort, earning himself statewide fame when in 1993 he successfully won a $115 million settlement against Fleet Finance over abusive lending practices in poor neighborhoods in Atlanta, a precursor of the subprime mortgage contagion.
Barnes managed to turn the fame of his Fleet Finance win into a successful run for governor of Georgia in the late 1990s. It was a time when he was seen as among the most promising of a new generation of Southern politicians. But Barnes saw there was more to the problem than just the usual mortgage scamsters. They now had a great power behind them—Wall Street. It would be a long time before Barnes would understand just how great a power that was.
Wall Street was becoming a different place. The transformation of Morgan Stanley that Partnoy had described, from the white-shoe restraint of yore to the blood-in-the-water culture of John Mack, was typical of what was happening to all the firms. The profits from derivatives and proprietary trading were too staggering. The competition was too intense. And in the low-interest-rate environment of the Great Moderation, investors were looking for new ways of obtaining higher yields. Now even traditional banks like Citigroup felt they had no choice but to go the same way as Morgan Stanley and the rest.
Robert Rubin himself helped to make that happen too, even after he left the Treasury Department.
Just a month after he departed Washington in July 1999, Rubin agreed to go to work for Citigroup as “chairman of the executive committee.” It was a largely ceremonial post in which Rubin would be used as a meet-and-greet eminence to snare big clients around the world. Still, the move shocked some of his biggest fans, who felt that the widely admired former Treasury secretary ought not to allow his pristine reputation to be tied to any particular corporate name. Rubin had been wooed by the irrepressible co-CEO of the giant bank, Sandy Weill. A shark for big opportunities, Weill had cornered Rubin almost immediately upon his return, at a “Welcome Back to New York” party thrown at the Metropolitan Museum of Art by Rubin’s wife, Judy.
Rubin wasn’t interested at first. He had not been entirely happy about the creation of financial supermarkets in his waning days as Treasury secretary. In a rare, perhaps unprecedented, public disagreement with Greenspan, Rubin had insisted that the Treasury retain regulatory control after Glass-Steagall repeal by placing the new bank powers in affiliates overseen by the Office of the Comptroller of the Currency (OCC). Greenspan wanted control through the bank holding companies, which the Fed regulates. Rubin expressed concerns about the way the law was written—just as he would worry aloud about derivatives, hedge funds, and leverage ratios. But the bottom line for Rubin was always the same: he didn’t take a firm stand when it came to standing in the way of Wall Street.
And now Weill made Rubin an offer he couldn’t refuse: At Citigroup there would be global travel and access to all the real-time data he had once enjoyed as Treasury secretary, unlimited time to go fishing, and $33 million a year in salary, bonuses, and benefits. Above all, there would be no line responsibility; he wouldn’t be running the firm. “I had had thirty-three years of operating responsibility at that point and I simply didn’t want to have it anymore,” Rubin told me later on. At the same time, Rubin badly wanted to stay atop the global economy; his position at Citigroup would allow him to know what was happening in China and elsewhere while taking it easy.
For Weill it was a bargain. He had built an investment banking and insurance empire, gobbling up Smith Barney, Salomon Brothers, and Traveler’s Insurance; his $76 billion merger with Citi the year before had been a final assault on Glass-Steagall. Weill and Citicorp chairman John Reed had done the deal betting that congressional repeal would happen, but now they had to wait it out. So bringing the world’s most respected financial official on board was an unmistakable message to the power barons in Washington, especially Rubin’s former protégés at Treasury and his admirers on Capitol Hill: finish off Glass-Steagall and permit the total crossover of traditional banking, investment banking, and insurance. “Snaring Bob was big news,” Weill wrote. “The press had been relentlessly calling into question our merger progress for months, and hiring someone as widely respected as Bob translated into a highly visible public endorsement.” Weill later proudly hung a giant wooden sign on his office wall with his picture on it and the words: “The Shatterer of Glass-Steagall.”
Rubin also played a critical role in the final—and ultimately nearfatal—evolution of Citigroup. Bit by bit, year by year, the dominant way of thinking in finance had been moving from traditional banking to investment banking, and then from investment banking to trading. By the time Rubin came on board, it quickly became clear to top officials at Citigroup that the co-CEOs, Weill and Reed, were hopelessly incompatible personally. Each represented a different and once incompatible culture that symbolized the strains between traditional banking (Reed) and investment banking/trading (Weill). The board of directors was divided between Weill appointees and Reed appointees.
The cerebral, conservative Reed, who had spent three decades rising through the ranks at Citibank, had rescued the bank from the debt disaster left by his predecessor, Walter Wriston, who engulfed Citi in defaulting Latin American loans. Reed rebuilt Citi’s brand around the world, creating a globe-dominating giant whose automated teller machines revolutionized consumer banking. Reed’s dream was to turn Citi into a global brand name, the Coca-Cola of finance. “I viewed Citigroup as the best bank in world,” said Edgar Woolard, who joined the Citicorp board in 1988 under Reed. “John Reed had us travel to Asia, South America, and Europe, and I saw how powerful Citigroup’s brand was in foreign countries. It was very profitable because the deposits were strong and lending was strong.”
But the merger hadn’t been working smoothly. In part it was because Weill was far less interested in building brand names than he was in increasing the new conglomerate’s stock price. “My interests are the shareholders,” he said. In part it was because traditional commercial and retail banking was an alien thing to Weill. “Sandy Weill had grown up in an environment where he had built a company that had businesses that weren’t regulated at all, whereas banks are heavily regulated. I could just see the tenor of the company changing to, ‘Let’s not worry so much about regulations,’” said Woolard.
At the time of the merger, Weill and Reed had agreed to retire together after two years as co-CEOs. One of the men, at least, had to go, and Reed had indicated a desire to fulfill his part of the retirement plan. Weill wanted to stay on. At a seven-hour-long meeting one Sunday afternoon in February 2000, the Citi directors hashed out who should take over as sole head of the company. Rubin—who at one point had been offered the post himself and refused it—was called in to mediate.
As Woolard recalled it, “Sandy’s outlook wasn’t looking too good” until Rubin came in the room and pulled off one of his classic acts of political jujitsu. Rubin disarmed the Reed supporters by announcing at the outset, “My beliefs and philosophies are closer to John’s than to Sandy’s.” But then he added: “If John wants to retire, I’ve heard the names of the people who might replace the two of them, and in my opinion keeping Sandy is better than bringing in any of the [outside] candidates we talked about.” Rubin’s remarks swiftly stunted a discussion about bringing back a brilliant young executive named Jamie Dimon, whom Weill had earlier fired, as the replacement CEO. Said Woolard, “That was an enormous factor in the final outcome, in my opinion.” The board anointed Weill sole CEO.
Bob Rubin had paid off again for Sandy Weill, the shatterer of Glass-Steagall. Sandy Weill would never take that sign down, while John Reed would one day apologize for helping to dismantle the law.
With the final eclipsing of Glass-Steagall—and the extinguishing of the last vestiges of Depression-era caution about finance—all the remaining divides between traditional retail banking and investment banking and other firms disappeared. The trend toward combining formerly separate financial sectors was vastly accelerated by the new mining to bundle loans into securities and sell them around the world. Global banks that had jumped without restraint into investment banking now also opened a vast conveyor belt of securitized loans from local towns to world markets. People by now had forgotten about the dangers of hot money, and they had also completely forgotten that the two cultures—investment and retail banking—used to be hostile to each other, that traditional banking was supposed to be meticulous and cautious, while investment banking and trading was buccaneering and bold. Now the bankers were overwhelmed by the buccaneers, who took over the ship. By the early 2000s, recalled financier Doug Hallowell, “being a traditional banker at a Wall Street firm was like being the last guy at the Alamo.”
At the same time, there was a desperate search for the next big trade. After the dot-com bubble burst in 1999, corporate profits and stock prices had remained fairly flat. Interest rates were still low; Greenspan deliberately had kept them low after 9/11, and while he would be harshly criticized for that too in later years—helping to inflate the housing bubble—he felt it was necessary to help the nation get back on its feet. But persistent low rates meant safe investments like government bonds continued to have low returns.
The only thing that still seemed to be going skyward in the early 2000s was housing. And with the derivatives industry now full of experience at basically converting anything into a bond to sell, the most tantalizing stuff around for investment managers seeking an edge was mortgage-backed securities based on high-interest residential junk loans. Wall Street always had a euphemism, of course. Just as it had once euphemized the Third World as “emerging markets,” now it euphemized bad credit risks as “subprime borrowers.”
The subprime concept was fairly straightforward: hard-up borrowers who didn’t qualify for normal, low-interest loans would have to pay off their mortgages at high interest, and those paybacks were funneled to the owners of the securities. While these risky mortgages once had been shunned by the Street, the ever appreciating real estate market meant that even indigent mortgage holders could always refinance. There was almost no requirement to put money down, so when subprime borrowers found they couldn’t keep up with their mortgage payments they simply took out a new subprime loan to pay off the previous one—and Wall Street, of course, snapped up the new loans and bundled them into yet a new round of securities. After the mortgage refinancing boom of 2003-2004, demand for fresh subprime “product” grew so intense that lending standards disintegrated altogether. Frank Partnoy’s old firm, Morgan Stanley, even sought to cut a deal with New Century, one of the giant nonbank mortgageurs that emerged in those years to slake the Street’s thirst, to buy $2 billion a month in subprime loans, no questions asked. To meet these needs, lenders kept reaching lower and lower down the scale of quality in both property and borrowers until the street hustlers jumped in to offer up their “product.” Wall Street held its nose and calculated that as long as house prices went up, even bad loans could get paid off. Most of them, anyway. In the late stages of the mania, the investment banks and hedge funds began playing a new game as well: creating synthetic CDOs actually designed to fail so that their creators could sell them short and bet on the collapse of the bubble. This meant that Wall Street firms were actively soliciting bad credit borrowers out in the heartland so that short sellers could make money on their defaults.
The major banks also began to buy up the nonbank mortgageurs themselves, the ones that were operating in states such as Georgia. One by one, the banks used them as a pipeline for more assets to securitize. Why not control the whole pipeline?
Down in Georgia, Roy Barnes—then newly installed in the governor’s mansion—wasn’t fully aware of how crazy things were getting in New York, but he had some idea. Mainly, he was worried about the way lending standards were dropping precipitously, especially in inner-city Atlanta. By this time, driven by Wall Street’s interest in securitization, many banks and other lenders were eager to find new markets, and the once-shunned inner city was a prime spot across the United States. That in turn led to the phenomenon of “reverse redlining.” Whereas back in the 1980s, the big story was the “redlining” of low-income, often African American neighborhoods by banks that refused to lend there, now the opposite happened. According to two major lawsuits later filed by Baltimore and Buffalo, banks now began to “discriminate” against these inner-city neighborhoods by making them particular targets of predatory lending.
Around the same time, Barnes was growing more and more concerned about the sheer volume of high-interest debt that Wall Street was securitizing. At least Fleet Finance had kept most of its paper on its books. Now all that bad paper, with Georgians signed onto at one end of the mortgage, had no responsible party on the other end. “I started seeing how securitization was really running rampant and taking away accountability for the banks,” Barnes said. By 1999 “I was convinced there was a calamity coming.” So Barnes decided to push through the toughest antipredatory lending law in the country. The bill made everyone up the line, including investment banks and rating agencies like Standard and Poor’s, legally liable if loans went bad in Georgia and were shown to have been fraudulently or recklessly issued. “There has to be accountability,” Barnes told me. “You have to be able to say, do I want to make this loan, because I may have to eat it.”
As the bill made its way through the Georgia legislature, the stalwarts of the Washington zeitgeist began arriving in Georgia, eager to offer Barnes advice. At first they were friendly, if condescending. Major rating agencies such as Standard and Poor’s and major mortgage issuers like Ameriquest let Barnes know in no uncertain terms that he was something of a “country bumpkin” when it came to banking, said his legislative aide, Chris Carpenter. “They treated us like mice interfering with this vast financial system.” Suddenly, the governor found himself besieged by lobbyists from major banks and national regulators—as well as Fannie Mae and Freddie Mac, the national mortgage issuers whose mandate was to help people obtain affordable homes at fair prices. What really agitated Fannie and Freddie, as well as the major banks, mortgage issuers, and rating agencies, was the idea that those who turned loans into securities and sold them around the world might actually be legally on the hook—liable—if the mortgages went bad. “They would say—and Fannie Mae and Freddie Mac were part of it—this is a complex market that has many levels,” said Barnes. “If you start interfering with the free flow of money, then Georgia will become an island that has no credit. I kept telling them, ‘You’re in for a crash here.’ ‘Oh no, we’re not,’ they’d say. ‘You’re a politician, we’re the experts.’” The well-heeled Washington lobbyists stood out in the state hallways in their expensive suits and alligator loafers. “I began to get paranoid, thinking everyone I saw was a lobbyist,” said state senator Vincent Fort, an early backer of Barnes.
When Barnes insisted on passing the law anyway, things got a lot less friendly. The advice turned to outright threats. Standard and Poor’s promised, in a letter, that it would rate no securities that contained Georgia loans. Ameriquest and major banks followed. Freddie and Fannie first asked to be exempted altogether, and then threatened to pull their business out of the state. No matter. Finally, Barnes had his triumph. On April 22, 2002, he flew through the state to sign the landmark legislation in seven different cities in front of TV cameras. Not only did the new law make buyers of loans liable, it mandated counseling for purchasers of “high-cost” predatory loans. “A victory for Georgia consumers,” the Atlanta Journal-Constitution editorialized on April 23, 2002, praising Barnes for drawing “on his political clout to stave off bank opposition.” Said Barnes, “It was hardest thing I ever tried to pass.”
But the governor and his comrades in the legislature had underestimated the determination of Washington to quash regulation of subprime lending, especially when it came from the states. The Washington interest groups feared the Georgia law would become national precedent. To permit liability even for fraudulent loans would be devastating to the global mortgage machine that had been set up. The industry gave up trying to strong-arm Barnes and sponsored fund-raisers for Barnes’s GOP opponent, Sonny Perdue. After Perdue upset Barnes in November of that year—largely, it is believed, because the Democrat removed the Confederate flag from the Georgia capital—his successor sponsored a much weaker law that removed the liability provisions.
The decisive moment in Georgia’s legislative debate came when a Republican senator stood up on the floor and declared that he was about to receive a letter from Freddie Mac threatening to cut the state out of its loan business. The speech applied the coup de grace to Roy Barnes’s law. “It broke my heart,” said Barnes. For a time after leaving the governor’s mansion, he went to work for Legal Aid, defending indigent mortgage holders.
That moment in the Georgia statehouse didn’t happen by accident. It was orchestrated by Freddie’s Washington lobbyists, who brazenly organized fund-raisers for members of the House Financial Services Committee, which has key jurisdiction over legislative issues relating to Freddie Mac, at posh D.C. restaurants like Galileo. A senior Clinton administration official said both Freddie and Fannie were powers unto themselves in forestalling additional regulation, thanks in large part to their lobbying power. “These guys are like the worst things I saw when I was in Washington. They are the singular embodiment of special interests and rent-seeking, with $170 million in lobbyist expenses, and every lobbyist in town on the payroll, with jobs for all folks in Congress after they leave office.” They virtually captured Congress, the official said—preventing any efforts at reform—with a brutal style of our-way-or-the-highway lobbying. “They basically make it clear there are two ways we can do it: if you vote with us, we’ll put on a big fund-raiser, and make you out to be a ‘hero of housing.’ That’s path A. Path B is we’ll do anything to get you defeated, we can send out twenty thousand pieces of mail to your district. So take your choice.” That view was endorsed by Representative Richard H. Baker, a Louisiana Republican who was chairman of the House subcommittee that oversees the companies: “When their interests are threatened, the response is almost armylike. They’re tactical, and they’re everywhere.”
The lobbyists were helped by the Washington regulators and the free-market mentality that prevailed. The OCC issued a preemption order saying the states did not have the authority to enforce laws against abusive national lenders. Tom Miller, the Iowa attorney general, said the comptroller of the currency, John “Jerry” Hawke, was spending all his energy on fighting state efforts to regulate, without paying attention to what the banks were doing in subprime securitization. “He kept saying the states are too strong in regulation, and telling the banks, ‘We’re not going to be as tough on you.’” The OCC was helped by the U.S. Supreme Court, which ruled for Wachovia Bank and its mortgage subsidiary in 2007 and against a Michigan state official, Linda Watters, who had claimed that federal law preempted her authority to regulate subsidiaries of national banks. Nowhere was the sense of state impotence greater than in California, which later became ground zero for subprime defaults. Most of the biggest abusers such as Ameriquest were head-quartered there, yet the state repeatedly failed at making its own firms legally liable for poor or crooked lending practices. When the feds tied the hands of the locals, “it was clear this was the Wild West, and there’s no sheriff in town,” said Jim Rokakis, the treasurer of Cuyahoga County in Ohio, who was also early to see the predatory lending problem. “If you’re a lender, there’s nobody who can stop you. The only difference is that in the old days people robbed the banks. Now the banks were robbing the people.”
There were a few doubters left in Washington. At the FBI in Washington, a senior agent named Chris Swecker began to get concerned about the level of fraud. “Based on various industry reports and FBI analysis, mortgage fraud is pervasive and growing,” Swecker, then assistant director of the criminal investigation division, told a House subcommittee in October 2004. It had “the potential to be an epidemic,” he said. But Swecker remained a lone voice. What prevailed was a simple disbelief among the feds and most of the Wall Street elites that there could be something that badly wrong with the market.
Even Alan Greenspan, in a speech to the Credit Union National Association in late February 2004, said that U.S. household finances appeared to be generally sound, despite rising debt levels and bankruptcy filings. The Fed chairman suggested that more consumers ought to take advantage of the “adjustable rate mortgages,” or ARMs, that were central to the subprime pyramid, because they allowed indigent borrowers to get a low initial interest rate in exchange for possible higher rates later on (it was okay as long as they could refinance on the basis of those constantly escalating home prices). “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan said.
It didn’t seem to matter that out in the country, at around the same time that Greenspan spoke, state attorneys general were fighting the deceptive lending practices behind these ARMs. In late 2005, forty-nine states and the District of Columbia won a class-action suit against Ameriquest over its deceptive lending practices, getting $325 million in compensation. Later on, Patrick Madigan, an assistant attorney general in Iowa—one of the states that led the Ameriquest case—was on a conference call with a senior official of one of the government-sponsored enterprises (GSEs), along with someone who had recently retired from a high position in one of rating agencies. Madigan was explaining to them what the attorneys general were finding at Ameriquest—that Ameriquest was engaged in widespread fraud. Systemic fraud. “One said to us: ‘What you are saying cannot possibly be true.’ Not ‘you’re wrong.’ It just can’t be true. . . . The reasoning was, one, if what you’re saying is true, it means massive amounts of fraud. . . . Two, it means we’re screw-ups.”
Greenspan worshiped the wisdom of the markets, but in truth he was mainly a real-economy man. That was his expertise. He didn’t really comprehend how complex things in finance were getting, how the instruments were so complex that even the CEOs of the firms didn’t understand them anymore. He occasionally agreed to intervene, but that was only in cases where foreign governments had botched things—Latin America, Asia.
Even in December 1996, when Greenspan had issued his famous warning against “irrational exuberance” as the tech bubble grew, he was prodded into it by his staff, which drafted the speech for him. “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” he asked. It was meant to be a message to the markets. But he never really followed up, and later he disowned the idea that the Fed could do anything about it anyway. He didn’t really want to believe the markets were overpricing, weren’t working. And when the tech bubble burst and the economy didn’t crash, it was some vindication for Greenspan. His Fed elevated into a doctrine the idea that it can’t deflate bubbles, but it can reinflate the economy when the bubbles burst. In 1999, an obscure Princeton economist named Ben Bernanke would supply the mathematical ammunition for that view and in so doing make himself the front-runner to succeed Greenspan. Irrational exuberance was a problem, perhaps, but not nearly as big a problem as any government solution to contain it. Similarly the Long-Term Capital Management bailout was evidence that banks could take care of their own problems.
In 1999—just as the housing market was beginning to take off—Greenspan gave up worrying about asset bubbles and told Congress “that the Fed would not second-guess hundreds of thousands of informed investors. Instead the Fed would position itself to protect the economy in the event of a crash,” he related later in his 2007 memoir. “‘While bubbles that burst are scarcely benign, consequences need not be catastrophic for the economy,’ I told legislators.” After all, markets in the long run were rational, and smarter than governments. Gerald Corrigan, by contrast, felt there could be a “tilt” to interest-rate policy to deflate bubbles; the Fed had a whole variety of supervisory tools. The Fed could, for example, impose higher capital requirements on banks, which would have dampened mortgage lending. Summers sided with Greenspan, in a 2004 interview with Business Week, about the Fed’s helplessness in dealing with asset bubbles.
Corrigan, from his perch at Goldman Sachs, continued to push for better risk management—and his work as cochairman of Goldman’s risk management committee would pay off later on. But he found that Washington was no longer interested. Six months after the Long-Term Capital Management disaster, Corrigan had overseen a report recommending enhanced regulatory reporting—frequent reports that would give firms’ exposure on trades, including over-the-counter derivatives. “We worked like hell,” he said. But Rubin, Greenspan, Summers, and the other officials in Washington rejected the idea. And Corrigan himself, representing now his investment bank’s interests, began to shrink from more aggressive proposals for a clearinghouse—which he later admitted was a mistake.
By the late 1990s, it sometimes seemed as if the only dissident left was Joe Stiglitz, the gadfly who wouldn’t shut up. Stiglitz tried again to do for the developing world what Roy Barnes had tried to do for Georgia—to put a brake on the excesses of finance capital. In a landmark speech in April 1998—around the same time that Brooksley Born was being silenced over at the Commodity Futures Trading Commission—Stiglitz sounded what was to be his valedictory warning about the dangers of too much certainty about free markets. Stiglitz made a grand plea to move beyond ideology, the black-and-white, markets-versus-government debate of the Milton Friedman era and the Cold War. He was appalled at the way the alternative Asian model had simply been buried, cast aside, reinterpreted so that even successful government restraints on capital flows were dismissed as aberrations not worthy of Washington’s attention. Stiglitz asked for a reasonable amount of scientific second-guessing when it came to the please-the-market prescriptions that the great institutions of Washington were handing out to the world. He harked back to the debate over capital account liberalization—still part of the conditions laid out for U.S. and IMF aid—declaring that the “scientific foundations” for opening up financial markets were just “not very sound.” He pointed out the differences between free trade in goods and services and free trade in financial markets. He noted that “empirical evidence, as well as recent experiences in East Asia and Africa, buttress the theoretical propositions that economies can suffer from too little regulation, just as they can suffer from too much or the wrong kind of regulation.” The biggest problem: the evidence for widespread economic gains was not really there, while there was considerable evidence that “opening up the capital account may subject the economy to more systemic risks.”
Stiglitz called for the champions of the Washington Consensus to be more sensitive to the very real differences in interests between, say, Wall Street investors and workers. A Wall Street investor is going to see the trade-off between inflation and unemployment much differently than a worker will; the former will fear the loss of value of his assets from inflation, while the worker is likely to be much more concerned about rising unemployment, and he won’t mind inflation if it helps to erode his debt. The government needed to be mindful of both views, Stiglitz said, if it was to get a social consensus for moving forward that would endure. But he kept going back to the theme of uncertainty, how much there was of it, and that “this uncertainty should, at the very least, induce a modicum of humility on the part of advisers.”
It was powerful stuff, but by then many of his opponents in the Washington Consensus saw only arrogance in Stiglitz. Why else would the man keep speaking against them? He just couldn’t admit he was wrong. He was too unrelenting in questioning them. At the Treasury Department and the White House, the view was that Stiglitz was impossible, a huge ego strutting around Washington who wouldn’t listen to anybody. By the time the Asian crisis seemed to pass, Stiglitz was being belittled all around town. In his book The World’s Banker, Washington Post economic columnist Sebastian Mallaby captured the view of Stiglitz that prevailed then, as an ineffectual rock thrower whining about market failures. “He was like a boy who discovers a hole in the floor of an exquisite house and keeps shouting and pointing at it. Never mind that the rest of the house is beautiful,” Mallaby wrote. His foes at the IMF turned on him with a vengeance, especially after Stiglitz suggested that senior IMF official Stanley Fischer, an eminent and much-beloved economist, had embraced Rubin’s policies in return for a fat job at Citigroup later on. Fischer’s former student at MIT, Ken Rogoff, the chief economist at the IMF, angrily accused Stiglitz of hurting the very people he purported to want to save by kibitzing. “In the middle of a global wave of speculative attacks, that you yourself labeled a crisis of confidence, you fueled the panic by undermining confidence in the very institutions you were working for,” Rogoff wrote in an “open letter.” “Do you ever lose a night’s sleep thinking that just maybe, Alan Greenspan, Larry Summers, Bob Rubin, and Stan Fischer had it right—and that your impulsive actions might have deepened the downturn or delayed—even for a day—the recovery we now see in Asia?” Rogoff concluded: “Joe, as an academic, you are a towering genius. Like your fellow Nobel Prize winner, John Nash, you have a ‘beautiful mind.’ As a policy maker, however, you were just a bit less impressive.”
It was odd, because everywhere else around the world Stiglitz had a reputation as a great listener. “The main thing about good economists, like good doctors, is empathy. I may not agree with you but I’ll listen to your point of view. He does that,” said Malaysian economist Andrew Sheng. Stiglitz’s family was also baffled by his reputation as a strident ranter in Washington. Every time they all took a trip together, Stiglitz would spend the whole time asking fellow tourists who they were and what they did for a living.
In the end, the enmity between Summers and Stiglitz grew too intense. The town really wasn’t big enough for the two of them, and Summers continued to have the upper hand in seniority, just as he had all decade. So what if Summers had been rejected at Harvard, and Stiglitz had gotten into Harvard but had turned Harvard down for Amherst? Or that Stiglitz’s work in economics was deeper and vastly more influential than Summers’s? Larry Summers had his hands on the levers of power, and no one in Washington really wanted to see Joe Stiglitz anywhere near the levers of power any longer.
Over at the World Bank, Stiglitz suddenly found himself frozen out of his job. By 1999, Rubin had left and Summers had taken over, as part of the deal worked out with Clinton, who took Rubin at his word that Summers was the only man who could replace him. Around the same time Stiglitz’s boss, Jim Wolfensohn, was looking for another term as World Bank president—a decision the Treasury secretary usually influences. But there may have been a price. In 1999, Wolfensohn genteelly asked Stiglitz if he might tone down his criticisms somewhat if he were to stay on as chief economist, and Stiglitz refused and resigned. Stiglitz was convinced that his old rival, Summers, had orchestrated his departure. Summers later denied it, and Wolfensohn told me, “I put no pressure on him to resign and, to the best of my recollection, was never put under any pressure by Treasury to bring about his departure, although I was of course aware of the tension that existed.” In a last parting shot, Stiglitz told the New York Times’ Louis Uchitelle that there was an “intellectual gap between what we know and what is still practiced” at the Treasury Department and the International Monetary Fund.
Wolfensohn announced Stiglitz’s resignation in November 1999. That same month, the great event that so many in the financial world had been working toward for almost two decades finally took place. Bill Clinton’s new Treasury secretary—the man who had once mocked financial markets as irrational—gave his approval to the historic passage of the Gramm-Leach-Bliley bill, which overturned Glass-Steagall. The new law allowed securities firms and insurance companies to buy banks, and it allowed the banks in turn to underwrite securities and operate brokerages without having to create nonbanking “affiliates.” Gramm-Leach-Bliley also effectively put in place voluntary regulation, since it did not provide for any SEC oversight of investment bank holding companies. Investment banks eager to buy up banks could decide to police themselves—or not. But Treasury Secretary Summers didn’t mention that in his statement that day. “Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the twenty-first century,” he said. “This historic legislation will better enable American companies to compete in the new economy.” Among those enthusiastically applauding was Summers’s fellow Democrat, New York senator Charles Schumer, the man who twelve years before had warned against repeal by saying it would turn the banking industry into a casino. “We’ve been working towards it for eighteen years,” Schumer declared, saying, “the future of America’s dominance as the financial center of the world is at stake. . . . If we don’t pass this bill, we could find London or Frankfurt or years down the road Shanghai becoming the financial capital of the world.”
Like so many others, Schumer now thought it was obvious why New York would want to be the financial capital of the world. What terrible consequences would come from London taking over went unsaid.
Summers wasn’t blind to the inequalities being created in the economy—the kinds of issues that Stiglitz was talking about. During his brief eighteen months as Treasury secretary, Summers cosponsored, with Andrew Cuomo at the Department of Housing and Urban Development, a pathbreaking report on predatory lending in inner cities. It was a report that would later catch the eye of a Bush administration official named Sheila Bair. And, smart economist that he was, Summers kept warning of overconfidence in the markets, saying colorful things like, “The only thing we have to fear is no fear itself.” But for the most part he still thought the future lay with even more deregulation. Shortly after he took office, in late 1999, Summers signed off on one more major new policy. He approved a President’s Working Group report in support of the deregulation of derivatives, a report that led to the most significant change of all. And since it occurred in the middle of the most dramatic and most serious constitutional crisis since Watergate, almost no one was watching.
11
The Canary in the Mine
Paul O’Neill was, in fact, a relic. An honest fiscal conservative from Pittsburgh, he had first come to Washington in the 1960s and then served as deputy director of Office of Management and Budget (OMB) under President Ford. After Ford lost the 1976 election to Jimmy Carter, O’Neill left Washington to embark on a brilliant corporate career, first at International Paper and then, from 1988 on, as chairman of Alcoa. He had entirely missed the era of free-market fundamentalism as it descended on Washington. Rooted in downtown Pittsburgh—which, while in Pennsylvania, is really a Midwestern city—he had resisted the era of deregulated finance that had given Wall Street the whip hand over the economy. O’Neill, like Stiglitz, was the product of a hardscrabble upbringing that made him mistrustful of bankers. Beyond that, he was too blunt for Washington, as he himself admitted. O’Neill had warned George W. Bush about this at their first meeting. “I like to say what I think, especially on subjects I’ve spent a few decades thinking through. In Washington these days, that might make me a dangerous man,” he told the president-elect, who just laughed and hired him anyway.
But he was dangerous. It quickly became clear that not only did O’Neill speak his mind, he had not been tutored at all in the zeitgeist. Looking and sounding like a real-life Mr. Magoo, he came out with one verbal snafu after another. At one point early on O’Neill openly scoffed that he didn’t need to consult the bond traders whom the Clintonites had sanctified. “I probably shouldn’t have said it,” O’Neill later recalled. “Someone said, ‘Aren’t you going to talk to people on Wall Street?’ And I said, ‘Why would I talk to people sitting in front of flickering green screens?’ But it’s true. Why would I?” He was, again, reflecting the prejudices of an earlier era, when Wall Street investment banks were handmaidens to big business, not their taskmasters, and when they answered to the regulators in Washington. “I had spent fifteen years at the center of government thinking twenty-four hours a day about public policy matters across the Office of Management and Budget. I was pretty confident that nobody in Wall Street thought about things that I had,” he said.
But now such sentiments had become sacrilege, and the statement cost O’Neill a lot of credibility.
It was soon apparent that Wall Street was returning O’Neill’s contempt in kind. O’Neill was always an odd duck. At Alcoa he had insisted that his company stay out of the reckless use of derivatives after reading a 1986 book on the “new financial world” by Henry Kaufman, the Salomon Brothers economist then known as Dr. Doom. Kaufman wondered somberly—and far earlier than most—how regulators would be able to stay on top of a global financial system in which the role of banks had waned and new credit instruments, including then-exotic derivatives, were taking over. Said O’Neill: “When I first started being concerned about broad patterns developing in financial markets it was in the early 1990s. Henry Kaufman’s book rang true to me. From the kinds of things that investment bankers were saying to me, I thought they were all lunacy. So I wouldn’t let our financial functionaries at Alcoa do any of that exotic stuff, the third- and fourth-order derivatives.” One of O’Neill’s assistant Treasury secretaries, Sheila Bair, recalled him telling her that “when he was CEO of Alcoa he would make them go over every derivative position they had, and if he didn’t understand it they wouldn’t do it.” He also had little use for investment banking in general. “When I was there, I honestly didn’t buy the idea that investment bankers really had very much to offer,” he said. “We had plenty of people inside International Paper who had a good education in finance. And they could do acquisition and asset sales better than investment banking houses. I was told we needed them for ‘a comfort opinion.’ I said, ‘We’re paying a bloody fortune for comfort.’”
O’Neill also had a hands-on pragmatist’s view of markets. He was a kind of Jerry Corrigan of the corporate world, believing that “people need to be protected from themselves.” At Alcoa, he had required that his twenty-six different businesses in forty-three countries produce, every Friday, a “one-computer-screen” report on important developments in their areas the previous week. “It gave me fingertip sensitivity on what was going on in the world. I had this vast feeder of information. I knew better than anybody in government what was going on in the world economy.” When he looked at the information-gathering and analysis systems at Commerce, Labor, and Treasury, he was appalled. “I said this is pathetic. A lot of this stuff is six months old.”
He really rolled into action after the collapse of Enron. “I called Sandy Weill—he was then running Citigroup. I said, Sandy, what are your credit card billings, slow payment and late payments and default data? I’d like to have them every day. He said, fine. I called Rick Wagoner at GM, said I need to know what your daily sales are.” O’Neill was creating a data-mining operation on the U.S. economy not unlike what he had done at Alcoa. “One of the things I was advocating was to require that CEOs of listed companies certify everything every three months, to make sure that what every intelligent investor needs to know is included and it’s all true.” Wistfully, he added, “By 2005, we would have had it in place. I think we would have pulled the trigger on it.”
Not surprisingly, O’Neill also hired people who were inclined to take a more Corrigan-like approach to finance. Among them was Bair, a lawyer from Kansas and a former Commodity Futures Trading commissioner, who upon taking office as assistant Treasury secretary for financial institutions in 2002 grew worried about looser lending practices. Prompted by Senator Paul Sarbanes, Bair read the report that Summers’s Treasury Department and Housing and Urban Development had prepared in the last months of the Clinton era. The report recommended that the Fed use its powers to write rules on lending—a point being pushed by Fed governor Ed Gramlich, who was a friend of Bair’s. But the Fed was still refusing. Appalled by this, Bair sought to impose “best practices” on the lending industry, including rules that would require documentation of a borrower’s ability to repay, and limiting refinancing to prevent “loan flipping.” Bair had solid Republican credentials; she had gotten her start in Washington as counsel to Senator Bob Dole. But Bair also found that she was shouting into the wind. After getting nowhere, she soon left the administration (though she would return in 2006 as head of the Federal Deposit Insurance Corporation.
O’Neill was a classic example of what economist Thorstein Veblen once lionized as a technocrat, the kind of professional who should be entrusted to run the economy. He’d befriended many Republicans over the years whom he had thought of as like-minded, among them Alan Greenspan and Dick Cheney. In 1988, George H. W. Bush had offered him Defense; he humbly declined, saying he’d just started at Alcoa, and he recommended Cheney. Cheney returned the favor twelve years later, but now was no time for technocrats, and O’Neill could seem to do no right—especially when it came to the now-outmoded idea of fiscal responsibility.
In the spring of 2002, after 9/11, O’Neill had the temerity to suggest that perhaps another tax cut was not a great idea. “I believed there was still a prospect of another 9/11,” he told me later. “The first one cost us one hundred or two hundred billion dollars,” he said. “We needed money to fix Social Security and Medicare.” Things got especially rough after the 2002 midterms, which the Republicans won handily. When Cheney pushed relentlessly for more tax cuts, and O’Neill worried aloud in a meeting about the rising deficit, Cheney barked that “Reagan proved deficits don’t matter.”
O’Neill, the author Ron Suskind wrote, “was speechless. Cheney moved to fill the void. ‘We won the midterms. This is our due,’ he said.” Seated at the right hand of a Republican president, working at the pleasure of a vice president who had been his friend and, he thought, his ideological ally, O’Neill found himself instead in an alien world. The movement that had begun with the more responsible ideas of Milton Friedman was now in the hands of an administration in which movement politics, not economic management, would predominate. During the Bush administration, wrote one of the original Reagan supply-siders, Bruce Bartlett, supply-side economics “became distorted into something that is, frankly, nuts—the ideas that there is no economic problem that cannot be cured with more and bigger tax cuts, that all tax cuts are equally beneficial, and that all tax cuts raise revenue.”
In keeping with the zeitgeist, the whole axis of opinion had continued to move rightward: If the Clinton Democrats were now fiscal conservatives, then the Republicans would be more passionate supply-siders than the Reaganites had been. O’Neill committed one of his biggest errors when he frankly admitted that Clinton had left things in good shape. “The Clinton administration pursued a really responsible fiscal policy,” he told me. “It’s true the economy was limping from the evaporation of the dot-com nonsense, but as we were going through 2001 the economy was not terrible. Interestingly enough, much to consternation of the economic types, even after 9/11 we didn’t take as big a shot as people thought.”
When O’Neill looked over his shoulder for the one supporter he felt sure would be behind him—his old pal Alan, the fiscal schoolmarm of the Clinton years—he found that the Fed chief wasn’t with him either. O’Neill and Greenspan had known each other since 1968, and the two worked closely during the Ford administration, when O’Neill had been at the OMB and Greenspan had been chairman of the Council of Economic Advisors. Greenspan had been on the board of Alcoa when O’Neill was recruited to become chairman, and afterward he would stop by the Fed for long talks with Greenspan whenever he was in Washington. “One of the things that bound us together is that we’re both analytic and numbers people,” O’Neill recalled. “It was a great joy to be engaged with Alan. I’ve known a few data mavens in my time, and he’s in the top rank.”
But Greenspan, his old friend, left O’Neill swinging in the ill wind of the Bush team’s tax cut fervor. Greenspan, who had campaigned so effectively for reining in the deficit during the Clinton years, suddenly decided he didn’t want to be seen as holding out against the latest wave of supply-side economics. “When I was making my arguments about the right and not-right things to do about tax policies, he was quiet,” O’Neill said.
The cold reception that O’Neill encountered paralleled, to some degree, what GOP moderates such as Colin Powell, Brent Scowcroft, and Senator Chuck Hagel of Nebraska faced in the national security realm. They no longer recognized the party they had grown up with. “Realism,” the traditional stance of the Republican Party, which depended on strong defense married to restraint and carefully cultivated alliances, was gone with the wind. Post-9/11, it was all unilateralism and hubris. As Scowcroft described to me the new Bush team’s attitude shortly before the Iraq invasion of 2003, a lot of it was about fixing what they saw as the squishy multilateralism of Bill Clinton and forth-rightly embracing America’s obvious destiny as the “hyperpower.” “They think that the United States has been in a Gulliver-like position for a long time, tied down by the Lilliputians [the rest of the world] from doing the things that we think are right. . . . This is no time for caution, it’s time to abandon your allies, your friends, and just go for it.” It was time, in other words, to reassert American power.
Yet before long, the president who had sought to reassert American power was presiding over its hollowing out on two fronts, said many critics. Among the critics, of course, was Joe Stiglitz. The long, bloody slog of Iraq was the more visible front of the drain on U.S. power. But behind the scenes the tax-cutting and deregulatory ideologues and derivatives termites were at work slowly undermining its infrastructure. It was a danger that, at the time, no one perceived, though O’Neill was certainly worried. Unsound finance could doom great powers every bit as much as conquering armies. “Behind each great historical phenomenon there lies a financial secret,” the British historian Niall Ferguson wrote later. Imperial Spain amassed vast amounts of bullion from the New World, but it faded as a power while the British and Dutch empires prospered because they had sophisticated banking systems and Spain did not. Similarly, the French Revolution was made all but inevitable by the machinations of an unscrupulous Scotsman named John Law, whom the deeply indebted French monarchy recklessly placed in charge of public finance. “It was as if one man was simultaneously running all five hundred of the top U.S. corporations, the U.S. Treasury and the Federal Reserve System,” Ferguson wrote. Law proceeded to single-handedly create the subprime mortgage bubble of his day with French public debt. When the debt bubble collapsed, the fallout “fatally set back France’s financial development, putting Frenchmen off paper money and stock markets for generations.” Wilhelmine Germany, meanwhile, came up short in World War I “because it did not have access to the international bond market,” Ferguson wrote.
Was the United States now, similarly, allowing its power to hang on a thin reed—its financial dependency on the rest of the world, particularly China? Larry Summers, now back at Harvard, called it a “financial balance of terror” in a speech. U.S. consumers overbought goods and overborrowed from China, and the Chinese in turn accumulated vast dollar surpluses that they plowed back into Wall Street investments, thereby supplying profligate Americans with the finance we needed to consume and sustain ourselves as the lone superpower. No one wanted to disturb the relationship, because it would be devastating for both economies, and so the world went on somehow, just as it had during the Cold War balance of terror. But how long could a great power last as a debtor to another nation across the world whose interests often clashed with its own? And what would the cost to the United States ultimately be? As Stiglitz would later write from his new high-profile perch at Vanity Fair magazine, lamenting not just the “war of choice” in Iraq but the failure to move the country away from oil or invest in education or social welfare, opting instead for more huge Reaganesque tax cuts: “A young male in his 30s today has an income, adjusted for inflation, that is 12 percent less than what his father was making 30 years ago. Some 5.3 million more Americans are living in poverty now than were living in poverty when Bush became president,” Stiglitz wrote savagely. “Up to now, the conventional wisdom has been that Herbert Hoover, whose policies aggravated the Great Depression, is the odds-on claimant for the mantle of worst president when it comes to stewardship of the American economy. Once Franklin Roosevelt assumed office and reversed Hoover’s policies, the country began to recover. The economic effects of Bush’s presidency are more insidious than those of Hoover, harder to reverse, and likely to be longer-lasting.”
Social equity, unfair tax cuts, above all a sense of balance—it’s what worried Paul O’Neill as well. But O’Neill got no hearing for these deeper worries. He had little sympathy on the outside either, in the markets. Robert Rubin and even Larry Summers were tough acts to follow. All most people saw with O’Neill was his Mr. Magoo side. Early on he helped to send the dollar into a tailspin with an ill-considered departure from Bob Rubin’s mantra in support of a “strong dollar.” O’Neill hadn’t quite abandoned the strong dollar, but like his boss, George W. Bush, he wasn’t especially good at nuance, and he had tried to make the sensible argument that the value of the dollar was simply the result of sound policy. (“We are not pursuing, as often said, a policy of a strong dollar,” he said. “In my opinion, a strong dollar is the result of a strong economy.”)
At another point O’Neill, dutifully trying to echo Cheney’s view of deficits, dismissed the U.S. current-account imbalances as “meaningless” in the face of America’s attractiveness as a source of investment. That was close to being economically illiterate: in fact, the vast amounts of capital flowing into the United States—into asset-backed securities, among other things—were arriving because Americans were consuming and borrowing, not because there were great investments here. No matter how hard he tried, time and again his ungoverned tongue got him in trouble with the markets. “Every time he got on TV, we would all say ‘Don’t talk!’” said one Wall Street trader.
The end came quickly. When O’Neill was dumped unceremoniously at the end of 2002 for daring to express public doubts about Bush’s tax-cut-and-spend approach to government, almost no one mourned his departure. No liberal hero, he still found himself in the same boat as people like Stiglitz and Brooksley Born.
O’Neill’s immediate successor, John Snow, a rail executive who seemed to have no discernible impact on any policy, lingered on through the first year of the second term, but he was seen as an ineffectual advocate of what were effectively unsustainable policies, and he was dumped as well. And as the budget deficit built through the mid-2000s, with an economy sustained only by the astonishing real estate market, George Bush needed a superstar to allay Wall Street’s growing concerns. The Greenspan era was coming to a close, and the man the Bush team was coalescing around as his replacement, an obscure economist named Ben Bernanke, wasn’t a superstar in anyone’s eyes.
Ben Shalom Bernanke had grown up in a small Southern town—Dillon, South Carolina—and like Stiglitz, he was part of that internal Jewish diaspora that assimilated itself throughout the United States, all the while maintaining its tribal customs in small synagogues. And like Summers, Stiglitz, and Greenspan, he soared academically. Bernanke looked a lot like Alan Greenspan on paper. Both were child prodigies at math—and musicians—and both men were acolytes of Milton Friedman. The great man himself, Friedman, in one of his last interviews before he died, in late 2005, told Charlie Rose that he felt good about Bernanke, that he was sure Bernanke would “continue in Alan Greenspan’s path.”
Beyond that, Bernanke had distinguished himself, and arrived at the precipice of the Fed chairmanship, by playing the eager acolyte to Greenspan’s view of the markets and the Fed’s role. His ascent in Washington was part accident, as is usually the case. As a Princeton economist, he and his longtime collaborator, Mark Gertler, had presented a paper in 1999, during the dot-com bubble, arguing against a strategy of using interest rates to deflate asset prices using interest rates. The paper did defend the Fed’s use of other tools such as regulation, especially in markets in which there was high leverage (not a major problem during the tech bubble that Bernanke and Gertler were addressing). But it caused some controversy: MIT eminence Rudiger Dornbusch attacked it, saying the Fed could do much more, monitoring loose credit on the way up in a bubble, and supplying credit on the way down. Still, the one man who counted then was Alan Greenspan, and he was impressed with Bernanke. “As we were filing out of the room Greenspan just happened to walk near us and said quietly as he passed: ‘I agree with you,’” said Gertler. “That had us in seventh heaven.”
Bernanke had in effect supplied scholarly ammunition to Greenspan’s doctrine of noninterference. Bernanke too had resisted the idea of the chairman giving his irrational exuberance speech. Later Glenn Hubbard, Bush’s chairman of the Council of Economic Advisors, recommended him for an opening on the Fed Board, and he performed as a loyal Bushie would be expected to. True to form, in 2002 Bernanke declared that “monetary policy cannot be directed finely enough [to prick bubbles] without risk of severe collateral damage to the economy.” Greenspan was so certain of Bernanke’s views that, when he handed off the Fed to him, he gave him only one piece of advice: When you have lunch with somebody, always arrange it so they sit with their back to the clock. That way you can see what time it is. After eighteen years, that was all Greenspan had to say.
Bernanke had hidden strengths—an almost preternatural calm married to a powerful intellect—that would become known and appreciated only later. Even as a teenager he seemed to have a calming influence on all those around him. His high school friend from Dillon, John Braddy, described a school trip when he and Bernanke were in Washington just after Martin Luther King Jr.’s assassination in 1968, and riots had broken out. “We were standing on the Capitol steps watching the smoke and fire from the riots. We had to be escorted out of the city. Being from the South, that really made an impact on us. But we never had a problem in our small town, and one reason is that Ben helped. He wrote several articles for the school newspaper about the future need for progress and integration.”
There are few times in world affairs when one man of consequence perfectly meets the moment